Chief Feedback Officers for public bureaucracies?

The Harvard economist, Greg Mankiw is reported to have said that his job as the Chairman of the Council of Economic Advisors to President George W Bush was not to formulate policies, but to "politely kill off bad ideas"! It is commonplace in governance to have egregiously bad ideas emerging and getting implemented without raising too much critical attention. It will be only after a few millions of dollars are frittered away, couple of years wasted, and even a few lives lost, that many of these ideas get abandoned. So how can we institutionally "kill off bad ideas" in public systems?

In fact, I am inclined to put this right up there at the top as one of our biggest governance challenges. Since very few people have the courage to tell that the emperor has no clothes, bad ideas and even worse implementation strategies persist. So how about an institutionalized agency for providing critical feedback on every new idea or initiative. All such policies could be filtered through the office of this agency before it sees the light of day. 

It is widely acknowledged that deficiencies in channelizing critical feedback on organizational performance or new initiatives is one of the most important reasons for organizations failing or under-performing. Such negative feedback, if appropriately channeled to the notice of the management and thenceforth acted upon, can become the difference between a successful organization and a normal one. Even at a theoretical level, negative feedback plays a critical role in stabilizing any physical system by acting to remedy (attenuate) the deficiencies (excesses) and lapses (deviations) within the system.

In the real world, criticism is not taken kindly in any organization, private or public. They are seen as an affront to the authority of the decision makers and detrimental to organizational discipline. Any informal or formal expression of opposition to a widely held view within the organization is often perceived as undesirable and gets institutionally suppressed.

However, in view of the most often clearly evident informational feedback value, organizations should be valuing negative feedback and be paying a premium for accessing them. In the circumstances, it may be appropriate to have an institutionalized role for those who can serve as sources of negative feedback for the organization.

A designated authority who focuses specifically on finding the negatives/cons in an existing process or proposed initiative can dramatically increase the inflow of valuable information and inputs that can go into increasing the quality of decision-making. The institutionalization of such post can free such critics from the shackles of political correctness and enable them to freely express their sceptical thoughts on the proposed reforms. And given the specific nature of their task, this is one activity that can be easily outsourced without generating too many conflicts of interest.

So how about a Chief Feedback Officer (CFO) who would act as a devil's advocate on existing processes/practices or for new initiatives proposed to be implemented within the organization. In order to signal his or her role even more starkly and drive home its cognitive salience, one could as well call them Chief Critical Officers. A CFO can play a critical role in getting bad ideas nipped in the bud. 

In many respects, such CFO's are more valuable in public sector bureaucracies than private ones. Government bureaucracies suffer from an acute problem of institutionalized suppression of all alternative points of view. Any criticism of government programs are seen as violation of conduct rules and becomes an object of mistrust and scorn. In fact, the absence of effective feedback about the prospects and implementation of government policies has for long been the bane of our governance systems.

These CFOs can become an institutionalized check against entrenched vested interests whose objective is to subvert well-intentioned government programs or push through bad programs that suit their interests. It also acts as a check against ideolgically blinkered decision-making. It is another matter that some of these critics themselves could end up becoming co-opted by these same interests. But on the balance, the numerous benefits far outweigh the few costs.

Further, an institutionalized role for critical voices will also by itself contribute towards increasing the acceptability of these alternative points of view and their ultimate incorporation into the public system and its decision making processes. 

The closest example of such a system is the American Congressional Budget Office (CBO) which seeks to provide objective and non-partisan analysis to aid in economic and budgetary decisions on a wide array of programs covered by the federal budget. In India too, the Prime Minister's Economic Advisory Council seeks to play such a role. But the inherent nature of decision making in countries like India means that such institutions should have a more explicitly negative feedback providing role.

The danger with CFOs is that once the file gets circulated with the negative feedback, in this age of CBI enquiries and activist judiciaries, the environment of decision paralysis could turn into a decision rogor mortis! Happily, there are also ways in which such a turn of events can be avoided!

The last-mile challenge in banking for the poor

It has always been thought that lack of access to formal bank accounts prevented poor people from saving more and once accounts were opened they would be able to more optimally manage their finances. But now that we have made some progress, albeit tiny (only 5.5% of 650,000 Indian villages have bank branches and half the adults in the country do not have access to bank accounts), with access through the campaign for total financial inclusion (TFI), have the desired outcomes been achieved for those people?

Surprisingly, it does appear that having a bank account does not automatically translate into its use, much less efficient management of personal finances. Livemint points to a study by Skoch Development Foundation which found that only 11% of 25.1 million no-frills accounts opened between April 2007 and May 2009 are operational mostly because of the high costs.

India Development Blog points to an IFMR study of the impact of TFI campaign in Gulbarga District of Karnataka (claimed to have achieved 100% financial inclusion), which found that 36% of sample households remained without access to formal and semi-formal savings mechanisms and more importantly, access to bank accounts did not translate into bank account usage. It was found that the accounts were used mostly to manage NREGS payments or SHG transactions. Critical to the lesser than expected account usage is the high transaction costs, especially by way of travel costs.

I am inclined to believe that even if access to formal banking systems, by way of opening a bank account, is increased, actual usage is likely to remain low unless bridge the last mile gap and take banking to the door-step of the people, especially in rural areas. The recent decision by the Reserve Bank of India to approve the deployment of mobile bank business correspondents, equipped with electronic terminals, to transact at the sub-branch level is certain to increase the quality of access. This will ensure that, unlike now, rural account holders are more likely to actively transact using their accounts.   

In this context, mobile phones have the potential to revolutionize banking and increase utilization dramatically. Mobile phones-based technologies offer the attraction of directly placing the bank account in the hands of the customer, thereby lowering transaction costs and increasing the likelihood of account usage. It may therefore be tempting to get carried away by this possibility, coupled with a campaign to increase financial literacy, and assume that it will ensure account usage.

However, dovetailing NREGS and other government cash transfers through TFI accounts, extensive use of business correspondents and mobile phone-bassed technologies, and financial literacy, while necessary are not sufficient conditions to ensure optimal account usage.In fact, unless complemented with other initiatives, mere increase in access to banking accounts, could be counter-productive. It could just as easily enable access to debt and other less than desirable financial products, whose extensive adoption could be detrimental to the interests of the poor people.

Behavioural science teaches us that even with access to their accounts and adequate financial literacy, human beings are cognitively constrained. This in turn means that despite firm commitment to save or spend on certain things, people tend to renege and fall short on achievement. People discount the value of later rewards by a factor that increases with the length of the delay. They are therefore tempted to spend on immediate needs as opposed to save for important long-term requirements. Further, drawing from theories of "mental accounting", it has also been found that people tend to save optimally when they they know what they are saving for.  

It is therefore necessary that the bank accounts are structured to address these cognitive biases. This assumes importance since we need to bear in mind that the ultimate objective is not to merely enable access to bank account, but to enable poor people with systems to more effectively manage their scarce finances. What can be done to ensure that poor people save more, optimize on their interest returns, manage their long-term needs like health care, children's education and pensions, make more effective purchase decisions, and so on? In simple terms, how do we ensure that people not only manage their finances effectively, but also overcome their cognitive urges which are often determental to their interests?

I have written about several examples of how innovative financial products can overcome such cognitive biases and increase the likelihood of optimal outcomes for poor people with management of their finances. In fact, bank savings accounts and financial products, with subtle commitment features, have the potential to dramatically increase not only usage but also effective usage of bank accounts. I have bloggged earlier about Save More Tomorrow, default pension savings, lottery savings products, products to increase fertilizer consumption, multi-tier accounts (also here), and budgeting family expenditures. See also this and this.

In this context, there is a big window of opportunity. Bill and Melinda Gates Foundation have just pledged $500 million to helping poor people learn to save money. They propose to fund research and project interventions in this area to emulate the examples like the hugely successful mobile banking for the poor — via cellphone in Kenya and Bangladesh and smart card in Mexico. Spurred on by the low domestic savings rate, this area has been the focus of considerable interest in the US too. It is appropriate that some part of this be leveraged into experimenting with financial products and structured accounts that help overcome cognitive biases.

It needs to be borne in mind that TFI and optimal utilization of bank accounts by the poor needs to go beyond mere door-step acceess to bank accounts.

More on public policy implementation dilemmas

I have blogged earlier (also this) about the complex dynamics of field-level decision making on public issues in India. Consider two examples typical with the water supply market in most Indian cities.

1. Given inadequate supply by the local water supply utility, private operators abound. They take water, either from the municipal network lines (most often by pilfering from even pumping mains) or from privately drilled bores, and supply them by tankers to buyers. The buyers include both slum dwellers and the affluent. These private bores are generally drilled without permission and their use leads to depletion of ground water levels. This often causes neighbours, who fear their home bores would run dry, to complain against these bore operators. When complaints become relentless, officials occasionally seize a borewell  or two (it is also true that officials take bribes from the bore operator and keep quiet!).

For every bore seized, the supply demand being satisfied by that operator is now unmet. Denied their regular assured supply and without access to adequate supply from the public utility, they mount pressure on their local corporator. He in turn challenges the public utility to make good the borewater supply deprived areas (which the supply capacity constrained utility cannot), failing which demand that officials release the seized bore. Since such supplies are a not insignificant share of the total supply, their disruption will immediately resonate everywhere. When faced with a choice of tightening enforcement and thereby depriving people off their drinking water supply or letting things as they are, the officials prefer the latter.

2. Water supply in most Indian cities do not meet the required flow-pressure requirements. It is therefore commonplace for consumers, especially in multi-storied buildings like apartment complexes, to connect motors to their delivery outlets and suck water in from the network at a higher pressure. This in turn means that the already low flow rate is reduced further for those not using such motors and also affects supply at the tail-end areas of the network. Invariably, slum-dwellers are the worst affected.

Utility officials often get complaints from slum-dwellers and are often forced into seizing motors in the vicinity. They soon realize that almost every large household has a motor. Further, it is not possible to confine their seizures to certain households. Apart from the administrative challenge of seizing huge number of motors, widespread seizures immediately raises a chorus of public criticism since those affected are also the opinion makers. For all its negative effects, the fallback option of motor pumps had had the effect of softening criticism against the utility.

In both cases - the clandestine bore operators and motor pumps - officials end up with a difficult dilemma. If they enforce rules strictly, they run the risk of upsetting the delicate balance of water supply dynamics at the field level. They'll face uncomfortable questions about the operational efficiency of the utility and their inability to supply adequate water will be exposed. In the circumstances, the natural preference for utility officials is to maintain the status quo and let things be.

This is symptomatic of problems elsewhere. Many apparently simple enforcement challenges in public issues have deeper underlying challenges. Efforts to enforce the regulations, without addressing the underlying problems, is not only not likely to increase welfare outcomes and efficiency but also exacerbate problems. In the circumstances, officials take the easy way out.   

The private Vs public sector debate in perspective

A dominant recurring theme in debates about development in India is about how the private sector can complement the government. In fact, there are a large number of influential voices who today feel that the private sector, if they are unshackled off their regulatory chains, can assume the dominant role in the development process.

In other words, they advocate that the government should put in place "the enabling framework" (translation - limited regulation and lower taxation) and should cede the space for the "markets to work its magic". At best, the government can continue to play a marginal role as service provider, if only to keep the markets competitive and honest.

Accordingly, it is suggested that governments should promulgate public policy that enables a dominant role for private sector in secondary and tertiary health care and education, urban infrastructure like water and sewerage, roads, electricity distribution and so on. In all these sectors, they argue, governments should step aside and free the private sector from regulatory restraints. They see government as having failed (and nonbody can dispute that) and therefore, as a corollary, the private sector should take over. So what gives?

There is no denying that over the past decade-and-half, the private sector in India has shown adequate capability to assume a greater role in this journey. However, this evidence cannot be stretched to conclude that the private sector is now capable of delivering the major share of the burden in delivering on these objectives. It is imperative that we place the role of private sector and governments in their proper perspective.

Let me illustrate this with the example of the provision of affordable urban housing. The mainstream debate on the issue is today focussed on putting in place an enabling framework that will help private developers bring more housing stock into the market, on unlocking the large chunks of government lands with various government agencies through public private partnerships (PPPs), and facilitating access to credit to home buyers. Supporters argue that these policies will help the private sector seize the initiative and meet the massive housing requirement for the economically weaker section (EWS).

This argument reveals a shocking level of disconnect with reality. The overwhelmingly major share of demand for affordable housing in cities comes from the EWS. Therefore, it is only appropriate that the priority for any policy that seeks to increase the supply of affordable housing should be on housing for EWS. This naturally means that LIG, MIG, and other categories of housing, while important, will be secondary priorities for public policy.

However, the aforementioned mainstream agenda is heavily skewed in the opposite direction. Private sector has an important, even dominant, role to play in the provision of housing for LIG, MIG, and other categories. But on purely commercial considerations, the burden of provision of EWS housing will have to vest with government.

Consider the commercials. The conservative cost of any decent 300 sqft multi-storied EWS house will be around Rs 2-2.5 lakhs. This is excluding the considerable cost of land and infrastructure. Assuming a tenor of 15 years and interest rate of 10%, a Rs 1 lakh loan will require an equated monthly instalment (EMI) of Rs 1100. This is about the maximum that an EWS household can pay. In fact, an EMI of Rs 800, which means a loan of Rs 75000 at the same terms, is a more realistic estimate. At the first estimate, assuming an upfront beneficiary payment of about Rs 20000, the subsidy will have to be Rs 0.8-1.3 lakh. Add in the land and infrastructure cost, the subsidy burden per unit will multiply a few times. Who is going to finance this construction subsidy? How many EWS beneficiaries can access banks for loan tie-up, especially given the massive NPAs banks have piled up in this category? Would it not be required for governments to use most of the available scarce pool of public lands for EWS housing?

Given this, governments will have to heavily subsidize any EWS housing schemes. Private participation will have to be confined to construction (on tenders), professional project management, and possibly outsourcing of rent collection and maintenance services. No PPP, innovative structuring of projects, or establishment of enabling policy framework can gloss over this reality.

In the circumstances, efforts to leverage private participation with allotment of government lands at concessional rates (or even free of cost) or provide generous fiscal concessions to developers, will merely constrain scarce public resources and detract from the more important and several times bigger challenge of building an adequate stock of EWS housing. In other words, by following the mainstream agenda, we will end up, at best, meeting the objectives with respect to a small part of the market, while overlooking the major portion of the market. None of this is to downplay the importance of LIG, MIG, and other parts of the market, but only to argue that its promotion should not come at the cost of the much larger market and public policy priority regarding EWS housing.

The choices that face public policy makers are stark. Should we allot scarce public lands to private developers or take up development on PPP so as to promote LIG/MIG housing or should we use them to develop stock of public EWS housing? Similarly, who should take precedence in the use of government's limited fiscal resources in the housing sector?

Similar analysis can be done for many other sectors to expose the ignorance that masquerades as informed opinion and knowledge in advocating a dominant role for private sector and a marginal role for government in the development process in those sectors. I believe that if governments have been found to fall short in delivering its objectives, the solution is not to simply abdicate the responsibility and cede ground to private sector. This would be unwise, especially in areas where the inherent nature of the problem makes the private sector unsuitable and government participation imperative.

In the circumstances, while encouraging private participation, the main focus of the debates should be on policies that strengthen the government's ability to manage such initiatives and increase their likelihood of success. The scarce financial and administrative resources of public agencies should be channeled towards ensuring bang for the buck with its full range of objectives. Simplifying the problem by taking the easy way out will only exacerbate the problem. Further, public policy should not be captured to fuel the interests of certain categories of consumers and participants within each sector.

The transformation of NREGS

My article in Pragati which examines the transformation of the NREGS from a demand-driven unemployment insurance program to a supply-driven employment creation programme is available here.

Too much of a good thing is bad!

Arguably the most famous debate in economics is between those advocating unfettered free markets and those proposing regulatory restraints and proactive government actions to address market failures.

The former claim that free-markets reduce market frictions and promote competition, which in turn generates efficient outcomes. They argue that the ability of markets to lower frictions and promote competition is a function of the degree of its liberalization. Unfettered free markets, they say, produces the most efficient outcomes.

The latter argue that market failures like externalities (both positive and negative), information asymmetry, moral hazard, unequal playing field among market participants etc can be addressed only with government action. Such actions take the shape of regulation, redistribution through taxation and subsidies, and sometimes even direct participation (like running schools and hospitals). In other words, public policies rectify market failures and strengthen free-market.

However, an examination of real world events reveals that markets fail and often fail spectacularly and with devastating consequences. A short history of the past two decades shows numerous examples of greater deregulation, in the direction of unfettered free markets, have failed miserably. Here are six examples of how lowering market frictions results in the reduction of market efficiency or does not lead to the desired outcomes.

1. Free market enthusiasts advocate policies that promote economic growth on the grounds that it can by itself contribute towards increasing incomes and reducing poverty. They see frictions caused by government regulations and restrictions on doing business as being responsible for lower incomes and poverty in many developing countries. However, there is increasing evidence from across the world that poverty and inequality reduction is better achieved by proactive government redistributionary policies and transfers than by mere economic growth.

2. Conventional wisdom would have it that greater choice reduces market frictions and increases efficiency. However, there is ample evidence, from a number of fields, that an excess of choices induce decision paralysis among human decision makers. Human beings are apparently not the objective and rational utility maximizing individuals.

3. Central Banks across the world have been pursuing greater transparency in their communication strategies, so as to bridge the market friction arising from information asymmetry. However the argument that this will promote more efficient shaping of market expectations may not turn out as expected. As I have blogged earlier, extreme transparency in central bank communcation need not always result in efficiency.

4. The wave of financial market deregulation and financial innovation across the world in the second half of nineties and in the last decade were supposed to lower market frictions and thereby increase financial market efficiency. It was believed that the light-touch regulation of financial market participants would facilitate more effective risk diversification and resource allocation and thereby lower both systemic risk and boost economic growth. However, as events of the past five years have shown, it has spawned several market failures - risk mis-pricing, resource mis-allocation, opaque financial instruments, systemic risks like too-big-to-fail and too-interconnected-to-fail, emergence of massive financial behemoths whose activities constrain market competition, and so on.

5. Theoretically atleast, arbitrage opportunities in financial markets arise from the presence of residual market frictions. Therefore, if any privileged information that becomes available were quickly traded away, that would increase the market efficiency. If this logic were correct, high frequency trading (HFT) would have improved market efficiency. However, there is enough evidence that HFT lowers market efficiency, distorts market incentives, and destabilizes markets.

6. Conventional wisdom would have it that completely free trade (which creates frictionless transactions) is the most efficient order. However, as Dani Rodrik has shown in his excellent recent book on globalization, as trade becomes freer and freer, its distributional effects loom larger and larger. In the context of the need to redistribute from the winners to compensate the losers, he shows that at very low tariff levels (as is the case with many countries in the post-WTO era), the marginal gain (say, increase in incomes or GDP) is dwarfed by the degree of redistribution required (from winners to losers). As trade gets more open, the redistribution-to-efficiency gain ratio shoots up. He writes, "It is inherent in the economics of trade that going the last few steps to free trade will be particularly difficult because it generates lots of dislocation but with little overall gain".

In all these cases, from hindsight it is not difficult to rationalize that the incessant pursuit of reduction of frictions contributed significantly to the failures. It removed the systemic checks and balances, institutional and psychological, that aligns incentives among all participants. Further, it also elbowed out the government from stepping in to mitigate markets failures.

Even assuming theoretically that frictionless systems generate efficient outcomes, there is the issue of whether it is possible to reach this state. If left to itself, after an infinite period, any market system may reach its equilibrium when all the ideal conditions hold. However, in the real world, we do not have the luxury of such timeframes and are therefore concerned in dealing with partially distorted markets. As the aforementioned examples illustrate, in such circumstances, there is the need to achieve a delicate balance of frictions.

In fact, Nobel laureate James Tobin, while advocating his famous Tobin Tax on cross-border short-term capital flows, argued about the need "to throw some sand in the wheels of our excessively efficient international money markets". Too little frictions and the resultant excessive efficiency is clearly bad for the system.

In this context, as Barry Schwartz explains in an excellent op-ed in the Times, frictionless free markets are akin to a "too much of a good thing" and they invariably result in sub-optimal outcomes. As the most recent example of reduction in market frictions by way of financial market deregulation and innovation has shown, far from increasing efficiency, such policies are likely to result in market failures and distortions. He writes about the benefits of the less efficient counterfactual,

If loans weren’t securitized, bankers might have taken the time to assess the creditworthiness of each applicant. If homeowners had to apply for loans to improve their houses or buy new cars, instead of writing checks against home equity, they might have thought harder before making weighty financial commitments. If people actually had to go into a bank and stand in line to withdraw cash, they might spend a little less and save a little more. If credit card companies weren’t allowed to charge outrageous interest, perhaps not everyone with a pulse would be offered credit cards. And if people had to pay with cash, rather than plastic, they might keep their hands in their pockets just a little bit longer. These are all situations in which a little friction to slow us down would have enabled both institutions and individuals to make better decisions.

Policy making and accountability

Consider this. The national economy is liberalizing and individual states are competing with each other to attract private investments. They try to out-bid their competitors by offering attractive concessions - tax breaks, concessional utility services, land at lower rates or even free, and so on - to external investors.

It is that early phase of liberalization and economic growth when investors are uncertain of the area's economic potential and pro-active industrial policy is required to incentivize them. In these circumstances, any policy that seeks to attract investors through open-competitive bidding or auctions are not likely to have many takers.

In many states, the industrial or investment promotion policy itself explicitly provides policy makers the flexibility to offer concessions depending on the competition. The state governments (and its political leaders and officials) exercise discretion, on case-by-case basis, to attract investors. While there are broad guidelines, many of the decisions on concessions and preferential allotments are made based on estimates of what would be required to incentivize the investor prefer this state over its competitors. In the process, as is inevitable with such discretionary policies, especially when the stakes are massive, there are instances of excesses, corruption and nepotism in the concessions offered.

Now fast forward ten years. Large investments have flowed in, the state industrial sector has much greater depth and breadth, and its economy has taken off. The conditions that necessitated the promotional policies have changed and the state has established itself as an attractive investment destination. Many of the same promotional policies, while still in force, stand out as obvious anachronisms.

Concurrently, a few sordid tales of discretionary policy corruption emerge, wherein politicians, officials, and corporate groups colluded to cause loss to the state exchequer. The popular outrage leads to an acrimonious post-mortem and revisit of all the industrial policy decisions taken ten years back. Investigations begin and many of the discretionary policy decisions taken to attract investments, including those done in good faith, are called to question on the grounds that it caused loss to the public exchequer and therefore get attributed with malafide intent. So what gives?

Any post-facto assessment, especially given the passage of time and the dramatically changed economic environment, of such decisions are liable to be flawed unless carefully done. Most importantly, it needs to avoid getting entrapped into examining the policies and resultant decisions against the backdrop of the prevailing macroeconomic environment and the lens of regulatory governance. Such cognitive biases and investigation norms are most often difficult to side-step.

The investigations have to draw the clear distinction between the discretionary investment promotion policy decisions taken on behalf of democratically elected sovereign governments in good faith and those taken with malafide intent. Further, the malafide intent has to be established by deep scrutiny of the facts and circumstances surrounding the allotments, instead of the automatic presumption from the (now) apparent excessively generous nature of the concessions allotted.

I will go even further. If the due process has been followed and the democratically elected government has, in its wisdom (or lack of it), granted concessions to a corporate group, howsoever generous, then the investigations should be confined to examining the evidence of any malafide intent behind the decision or failure to adhere to the procedure established by law in its implementation. As to the magnitude or extent of concessions or the policy paradigm (say, auctions against the discretionary allotments) followed, I strongly believe that its adjudication should be left to an appropriate forum, say, the judiciary or the respective appellate tribunals. Atleast in democracies, any investigation by any subsequent governments, should adhere to the aforementioned principles.

In the absence of such protection, any exercise of judgement, on the part of an official or political leader, however well-intentioned, can be questioned subsequently on grounds of having caused loss to the public exchequer. All such decisions, by their very nature, incentivize and provide preferential treatment to one investor, so as to encourage them to invest in the state. Perforce they involve immediate loss to the exchequer. The trade-off is the expectation that it will set the platform for industrial growth and the recovery of the short-term loss through longer-term gains from economic growth.

If this subtle dimension to policy making is not appreciated in any post-mortem, the moral hazard generated by the apprehension of a possible future implication, will restrain policy makers from making judgement calls on such policies. An environment of decision paralysis will result.

Unfortunately, as this environment of suspicion and media trial gets entrenched into the psyche of civil society and defines the agenda of mainstream debates, policy making that involves any exercise of judgement will become a minefield. It will handcuff even those officials whose intentions are in the larger public interest.

This argument is not in anyway an approval or condonation of the obvious irregularities and corruption that have been a characteristic feature of investment promotional policies in many states and at the center in the past decade or so. Those responsible for the malafide actions and administrative irregularities that caused loss to the public exchequer should be punished and the deterrent against such actions strengthened.

However, this should not be at the cost of simplistic appraisals of complex decision-making environments that can only end up paralysing decision-making at all levels and turning the country into a banana republic. It is also pertinent to point out that the propensity for such excesses and corruption are an inevitable accompaniment to economic development in emerging markets.

The descent into a Banana Republic?

The quality of debate surrounding the Supreme Court's decision to cancel 122 2G spectrum licenses with the "stroke of a pen" is a reflection of the standards that prevail in public issue discourses in mainstream media in India.

Stripped off all its sensationalism, the 2G spectrum issue essentially boils down to this. The Government of the day, in its wisdom (or lack of it) and well within its rights, put in place (or inherited) a discretionary telecommunications spectrum allotment policy. However, in its implementation (during the 2008 allotments), there were clear discrepancies and irregularities, atleast in case of some of the bidders, that leave no doubts about malafide intent.

So the Supreme Court - three years after the allotments are made, operators have stabilized their full commercial operations, and a web of contractual obligations involving different market stakeholders have emerged - steps in and examines the evidence on corruption in the allotment process and puts a full-stop by cancelling all the spectrum allotments made during that period. What's more, it goes beyond the malafide intent and questions the government's use of a discretionary allotment policy and effectively seeks to "legislate" an "auction-based" allotment process. A nascent mobile telecommunications market-space, the equivalent of a mid-size European country, is decreed to be wiped out in four months.

Now consider this. A newly elected democratic government of Banana Republic, a war torn and military-ruled country in the continent of Timbuktu, decides to encourage foreign investments to boost its economy. It offers attractive concessions like free land, tax holidays, and so on in mineral exploration and manufacturing sector. Investors flock to Banana Republic, enter into sovereign contracts with its government, and start exploration and manufacuting activities. The economy booms, tax revenues increase, and the country starts its recovery from its war-era devastation. There are the inevitable tales of cronyism and corruption in some of the contracts awarded, all of which have aroused some national indignation. Then disaster strikes and the military takes power. Its first act is one of deep populism. It plays on the national resentment at the corruption in contracts signed with foreign investors and cancels all sovereign commitments of the previous government and expropriate the foreign investments. Banana Republic slips into its normal state of turmoil.

Apart from the different exterior trappings (the cancellation was at the "stroke of a pen" in the former, while it was at the "boom of a gun" in the latter), on substantive terms, is there any difference between the two scenarios? In both cases, sovereign policy commitments made by the respective democratically-elected governments of the day (whatever its flaws) and implemented deficiently (as is the case with any implementation in such societies) are, without any of the legal requirements of fairness and justice, cancelled over-night at the arbitrary discretion of a few individuals. In both cases, apart from moral hazard arising from defaulting on sovereign commitments and the long-term economic damage caused, the decision-makers have clearly over-looked the fact that much water has flowed under the bridge subsequent to the "original sin". The decisions extinguished the multiple economic transactions and contractual commitments - many of them without any malafide intent, based on legally valid legislative and executive decisions, and a consequence of the natural flow of economic activity - that have emerged after the original decisions/allotments.

Not for a moment am I holding any brief for those who violated their constitutional responsibilities or who benefited fraudulently. All of them should be brought to book for their criminal liabilities. The political masters, bureaucrats, and the businessmen who colluded to defraud the exchequer should all be throughly investigated, their criminal intent established and punishment imposed. For example, the public servants who took part in the conspiracy should be punished under the prevailing rules, while the businessmen who benefited from it should be punished under the relevant rules and the amounts defrauded quantified and collected from them and their partners. This should be done in a manner that least disrupts the competitive marketplace (and even its critics would admit that the economic outcomes - technology, business models, consumer surplus etc - of India's telecommunications reforms has been one of its economic and policy success stories) that has emerged from the original decisions.

In any case, the sovereign policy commitments of democratically elected governments, however flawed, should always prevail and not be left at the mercy of flippant individual discretion, howsoever mighty, provided the allotment process is in conformity with the broad constitutional principles. This becomes all the more important if subsequent transactions, in good faith and based on the sanctity of a sovereign commitment, have been executed on the original decision. However, law should take its course and severely punish those who displayed any malafide intent, discrepancies, and wilful omissions in the implementation of the allotment process.

The term "banana republic" is characterized by two features - a country operated as a commercial enterprise for private profit and one where the sanctity of long-term policy commitments of any of its governments is of questionable value. On these grounds, does India qualify to be a "banana republic"?

Central Banks hold sway, where are the governments?

There is a common feature in the respective policy responses to the current domestic economic situations in United States and India. In both countries Central Banks are at the frontline fighting the battle, while governments appear missing in action. In many respects, both the Fed and the RBI are, in different ways and degrees, fighting not only the monetary policy but also the fiscal policy battles. This over-reach in both areas is unsustainable and is generating distortions that could set the stage for even bigger crises.

More worryingly, not only do the central banks themselves appear convinced of their leadership role, but everyone else too believes that they should keep doing more. In the process, governments are getting away lightly. Nothing can take away from the fundamental fact that only governments can sustainably bring a closure to the ongoing economic crisis and set the stage for a more sustained economic recovery.

In the US, since late 2008, the Fed has unveiled a series of policies, ranging from classic monetary policy to outright fiscal policy, to not only keep the credit market open but also to backstop aggregate demand from falling and stimulate economic growth itself. It has lowered rates to near zero and has committed to keep there till end-2014 (a period of over 6 years of extraordinary monetary accommodation), multiplied its balance sheet many-fold to over $3 trillion by purchasing a large category of assets and injecting massive quantities of liquidity, and is now experimenting with greater transparency in communicating the Fed's monetary policy processes so as to mould market expectations.

In contrast, apart from the initial stimulus plan, ARRA, the US government has largely remained at the sidelines. All this, while averting a financial meltdown and deep deflationary economic recession, has created several incentive distortions, besides postponing important adjustments. Mohamed El-Erian summed it up nicely in a recent FT op-ed,

"Despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions. Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures."

Unlike in the US where economic growth and financial market stability have been the central themes, inflation and burgeoning public deficits have been the biggest concerns. RBI has been pitchforked into the frontline of the inflation battle. In turn, since the onset of the initial signs of economic strains and inflationary pressures in early 2010, the RBI has increased interest rates 13 consecutive times. In the process, it has tempered the over-heating economy and appears to have brought inflation down to more tolerable limits.

It was evident to anyone who cared to go beyong stage one that India's inflation problem was fundamentally a supply side problem and could be sustainably managed only by easing supply constraints, especially by removing infrastructure bottlenecks and increasing foodgrain production. RBI's inflation fighting policies only managed to cool the over-heating economy and bring it down to its constrained production possibility frontier.

This long-period of inflation-fighting by monetary tightening was an ideal opportunity for the government to undertake policy measures and reforms that would initiate the process of declogging the supply-side and pushing up the production possibility frontier. But nothing of that sort was forthcoming. Worse still, the government added to the problem with a series of fiscal largesse, unconcerned about the severe fiscal strains that were clearly evident.

This in turn increased government borrowings and boosted aggregate demand at a time when supply was severely constrained, therefore adding to the inflationary pressures. With interest rates rising, inflationary expectations anchored upwards and policy parlysis gripping government, investment climate weakened. Instead of expanding aggressively in a growing economy, cash rich businesses turned off their investment taps and have preferred to wait and watch.

Now, with the inflationary pressures easing, the onus is again back on the RBI to take the centerstage. Everyone calls on the RBI to lower interest rates to encourage investment. Critics accuse it of being "behind the curve" in lowering rates, just as it was accused of being similarly slow to raise rates in the first place as the recession struck.

For sure, in the coming months, the RBI will lower rates and cost of capital will come down. Businesses will start investing and economic growth will recover somewhat. But all that will be pyrrhic victories if interest rate cuts are not accompanied with policy reforms to ease supply constraints. In its absence, we will witness another short-cycle of boom followed by over-heating and slowdown. The RBI will again be forced to step in an re-enact its current role.

Markets and central banks alone cannot set the foundations for economic growth. Governments have a critical role to play in laying the policy framework for expanding the economy's production possibility frontier. Markets thrive on the enabling policy environment established by public policy actions. Paralysed governments, which cede responsibility to technocratic institutions like central banks, are merely kicking the can down the road.

Satyajit das has an excellent article in FT which outlines the distortions caused by a prolonged period of ultra-low interest rates.

Update 1 (30/4/2012)

An excellent FT op-ed on how leveraging central bank balance sheet has come to be seen as the least costless route out of a financial crisis induced recession. The unprecedented liquidity injections have undoubtedly helped backstop the lurch into full-blow depressions. By early 2009, the Fed, the ECB and the BoE had all cut their main policy rates to all-time lows, and it has remained there since. However, the challenge for central banks is not to manage the retreat from these accommodatory policies before stoking inflationary pressures and without suffering massive losses.

The use of the balance sheet as a policy tool is no longer likely to be considered unconventional. The crisis has moved it to the centre.

 

Discretionary public policy - the case of 2G spectrum allocations

This post will be provocative. I have a simplified interpretation of India's controversial 2G telecoms spectrum allocation process.

The fundamental issue is that the government of the day decided to allocate the spectrum without any competitive price discovery process, and subsequent events (spectrum resales by a few purchasers) point to the allotment having been made at a steep discount thereby causing huge losses to the public exchequer. In simple terms, the spectrum was sold cheap, and private spectrum purchasers benefitted at the expense of the tax payers.

Critics of the allotment process claim that if the spectrum was auctioned off, as happened with the subsequent 3G auctions, the government would have raised huge amounts. The bidders would have paid close to the actual cost of the spectrum. There would have been no corruption. So what gives?

Here is a thought experiment. I can imagine two forces that were generated by the low spectrum prices.

1. The substantial discounts enabled the telecom operators to keep their initial fixed investments low. They now had resources to spend on technology and more importantly, aggressive expansion. Furthermore, it gave all players the initial cushion to establish the market, without having to over-charge. Such over-pricing is a characteristic feature of any nascent market, as the first generation of firms try to establish themselves. It generally takes time before the market stabilizes and the firms start responding to market competition signals.

2. It cannot be denied that the lower spectrum prices dramatically reduced entry barriers and contributed towards creating an intensely competitive marketplace. The threshold cost to enter the market was lowered. In simple terms, the government subsidized the private operators significantly.

As the private operators got established, the market stabilized, customer base exploded, these two aforementioned factors interacted to generate fierce competition. This competition benefited the customers and the market itself.

Consider the counterfactual. Assume the spectrum was allocated by auctions. It is most certain (especially given the information asymmetry in a new market) that the process would have been affected by "winner's curse", whereby bidders would have quoted a premium on the fair market value. The successful operators would have entered the market with strained balance sheets and limited inclination to be aggressive in their investments and pricing. Instead of spectacular explosion, the market would have grown in fits and starts. Most certainly the government would have had to intervene subsequently to prop up the market with various types of fiscal concessions.

The central point I want to make is that the discounted allocations provided the operators with the required cushion to be aggressive and innovative in a nascent market. This in turn helped lay the foundation for a very competitive and vibrant telecoms market in India. The aforementioned dynamics is true of any emerging market. China is the best and most recent exemplar of the wastage, excesses, and corruption that lubricates such emerging markets.

In any typical emerging market, governments provide considerable fiscal support, directly and indirectly. In its absence, the only way in which a market can emerge is if large foreign competitors, with deep-pockets and a commitment to take sustained losses for some time, enter the market.

Much of this support is not planned and is a response to problems posed by emergent difficulties in the growth process of the particular sector. In fact, there is considerable corruption (sanitized through lobbying which conceals an equally nauseating underbelly of quid-pro-quos) involved in these policy decisions. It would be interesting if we could compare the fiscal support given to sunrise sectors like IT and biotechnology with that given to the mobile telecom sector.

The critical governance question here should be about the extent of malafide discretion involved in the allotment process. The acrimonious post-mortem has revealed that the government, or influential people within the government, played an important role in picking winners and enriching themselves at the cost of the public exchequer. It is this market failure that should be the cause for the greatest concern.

This also raises another question. If auctions would have led the market into a low-level equilibrium and discretionary allotments spawned massive corruption, what is the alternative? What process of allotment would have given the participants with the required cushion and allowed the market to develop fast without causing incentive distortions that spawn corruption? I am not sure there is any such process.

This brings us back to the inevitability, even desirability, of discretionary public policy, espcially in incubating new markets. In the circumstances, the focus should be on minimizing corruption in the discretionary public policy making space.

The competition dynamics beneath China's economic success

Enlightened public policy, intended or otherwise, has surely played a major part in China's economic success for the past nearly quarter century. However, there remain serious debates about what specific policies contributed to this success.

In this context, a NYT article points to the positive role played by public policy in unleashing fierce economic competition among its city states and the central role of urban development in driving economic growth. Though these city states - semi-autonomous regions within large provinces - are built around a huge urban metropolis, a major portion of its population lives in the rural areas surrounding the city. It writes,

"When it comes to economics, China is more a thin political union composed of semiautonomous cities... than an all-powerful centralized government that uniformly imposes its will on the whole country. And competition among these huge cities is an important reason for China’s economic dynamism. The similar look of China’s megacities masks a rivalry as fierce as that among European countries.

China’s urban economic boom began in the late 1970s as an experiment with market reforms in China’s coastal cities. Shenzhen, the first "special economic zone", has grown from a small fishing village in 1979 into a booming metropolis of 10 million today. Many other cities, from Guangzhou to Tianjin, soon followed the path of market reforms.

Today, cities vie ruthlessly for competitive advantage using tax breaks and other incentives that draw foreign and domestic investors. Smaller cities specialize in particular products, while larger ones flaunt their educational capacity and cultural appeal. It has led to the most rapid urban "economic miracle" in history."

Each of these city states has a municipal government, which administers both the urban and rural parts. A very tightly enforced hukou (household registration) system limits migration into cities. Those living in the countryside are also registered as farmers and receive various welfare benefits. Though the focus of the city governments have hitherto been confined to the urban center, it is now shifting to the countryside, partly in an effort to retain people in the suburbs and villages so that the city does not get too congested and its growth gets choked. Some municipal governments have set up development zones composed of small firms (mainly export-oriented) in the rural areas.

China's experiment has important lessons for India's federal system. Drawing a parallel with Beijing's policy towards city governments, is it possible for the central government to align policy incentives in a manner that helps create an environment that promotes competition among states? What should be the elements of such a policy framework that does not conflict with India's federal system? What should be the support that the central government should provide for each of these elements?

Why taxes are important to reduce poverty and inequality?

Free market conservatives oppose big government and favor reduction in taxes as the preferred route to the achievement of economic growth. They argue that governments are inherently ineffective in efficiently allocating resources and therefore should give way and facilitate private enterprise to achieve the same objective.

They claim that economic growth, thus achieved, will "trickle down" to benefit everyone by way of more jobs, higher wages, and better living standards. They therefore advocate that government's role should be confined to unshackling the restraints to private enterprise and providing everyone with the basic opportunities - health care, education, and skills - to compete in the market.

However, as Lane Kenworthy (see also this earlier) points out with empirical evidence, reality is not as simple. In fact, examining the trends in income levels among those at the lower end of the income ladder in the advanced economies since the 19760s, he finds that it was not trickle down but direct transfers that kept incomes growing. He writes,

"In almost all of these countries (Ireland and the Netherlands are exceptions) the earnings of low-end households increased little, if at all, over time. Instead, increases in net government transfers — transfers received minus taxes paid — tended to drive increases in incomes when they occurred."

The graphic below captures the average household income in the bottom decile of the posttransfer-posttax income distribution. Group 1 is Denmark, Finland, Ireland, Netherlands, Norway, Sweden, and United Kingdom, while Group 2 includes Australia, Canada, Germany, Switzerland, and United States.



Clearly, incomes have increased substantially after transfers for those in Group 1. In fact, Kenworthy goes further and argues that jobs and higher wages cannot produce the same trickle down effect on those at the bottom end. He writes,

"At higher points in the income distribution, they do play more of a role. But for the bottom 10 percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time, some will be out of work due to structural or cyclical unemployment. And in all rich countries, a large and growing number of households are headed by retirees. We surely can do better at helping able adults get into (or back into) employment, but we shouldn’t pretend that paid work is a realistic route to guaranteeing rising incomes for everyone."

He also points to the importance of keeping income transfers dynamic enough to ensure that its share of incomes do not fall appreciably with time. He draws attention to the fact that in most affluent nations, including the Scandinavian ones, while transfers have increased, it has not done so at the rate required to keep its share of the GDP from falling. He writes,

"In most of these affluent nations... increases in the share of GDP allocated to public transfers largely stopped after the 1970s. In recent decades, the distinction has been between countries that kept transfers rising in line with GDP versus those that did not. Sometimes doing so requires no explicit policy change, as benefit levels tend to rise automatically as the economy grows. This happens when, for instance, pensions, unemployment compensation, and related benefits are indexed to average wages. Increases in other transfers, such as social assistance, typically require periodic policy updates. That’s true also of tax reductions for low-income households."

In particular about the US, his suggestion is,

"What the income data tell us is that the United States has done less well by its poor than many other affluent nations, because we’ve failed to keep government supports for the least well-off rising in sync with our GDP... Modest, regularized increases in the inflation-adjusted benefit levels of existing social programs — the Earned Income Tax Credit, unemployment compensation, social assistance (TANF and SNAP), housing assistance, and disability benefits — would yield significant improvements in the incomes of America’s least well-off."

Kenworthy's findings carry important lessons for policy makers in India. It clearly establishes that economic growth alone cannot address the problems of poverty and inequality, all the more so in regulated and under-developed markets like India. Government transfers are more important in achieving poverty reduction objective, especially for those at the bottom of the income ladder. However, there are two points of qualification.

One, transfers can be meaningful only when the the fiscal balance is in order and governments have the resources to carry out such transfers. Robust economic growth is the only route to keeping public finances in good strength. Two, it is important to ensure that these resources are utilized to deliver bang for the buck. The most effective strategy to optimize public spending is to channel it towards those activities which address market failures and enables equality of opportunity to all citizens in accessing the market. This requires a very scarce commodity - far-sightedness in public policy making.

India's growth dilemma in a graphic

I am labouring this point. Cities are already India's economic growth engine. In the years ahead, they are estimated to contribute 70% each of the national economic growth and all new jobs created. But rural India, where 65% of the population lives, takes up the major share of public spending and administrative energies. The graphic below summarizes India's public policy priorities.



This skewedness may be guilty of killing the goose that lays the golden eggs. India needs to grow near the double digit rate so that its tax revenues and new jobs created grow fast enough to meet the massive and growing demand. Higher tax revenues would provide governments with the necessary resources to expand public investments, both in rural and urban areas. Faster pace of job creation would provide adequate opportunities to accommodate the rapid additions to the workforce. It would ensure that the danger of our demographic dividend turning sour is averted. And, as I have blogged earlier, transfers are a function of tax revenues. Higher the tax revenues, more the resources available to reduce poverty and mitigate any rise in inequality through effective redistribution policies.

Unfortunately, both state and district-level public policy and public spending (investments and welfare spending) are disproportionately focussed on rural India. Much more needs to be done for rural development. But a more effective strategy to achieve that objective would be to strengthen the urban growth and job creation engine and then utilize the resultant growth in tax revenues to promote effective rural development.

Purchasing and pricing health insurance

As health insurance assumes centerstage in health policy debates in India, it is critical that we make informed decisions on the two critical factors in any health insurance model - purchase and pricing of medical care services.

In this debate there are two issues - how care is purchased and how much is paid for that service. There are two conventional approaches to purchasing medical services. Insurers can pay the service providers a specific amount for each discrete service (fee-per-service model) or make bundled payment for all of the care a patient needs over the course of a defined clinical episode.

The former is the prevailing purchase model across countries and has its set of inefficiencies. The biggest problem with this approach is that it becomes difficult to manage the incentive of doctors and hospitals to prescribe more diagnostics and treatments than is required. Insurers manage this problem by increasing the effectiveness of their pre-authorization and/or with conditions like prohibiting payments for certain basic tests. In contrast, the later approach effectively addresses this incentive problem. However, it fails with implementation problems.

Regarding the pricing of these services, different insurers can either individually negotiate with the service providers and arrive at their different price schedules or they could collectively bargain and fix standardized prices for all insurers. The US health insurance market is a classic example of such price differentiated market and its inefficiencies are well documented. Government-run health insurance systems undertake collective bargaining and fix standardized prices for each service.

Uwe Reinhardt summarizes the merits and demerits of both approaches and advocates the All-payer model,

"In developed nations that rely on multiple, competing health insurers — for example, Switzerland and Germany — the prices for health care services and products are subject to uniform price schedules that are either set by government or negotiated on a regional basis between associations of health insurers and associations of providers of health care. In the United States, some states — notably Maryland — have used such all-payer systems for hospitals only. Elsewhere in the United States, prices are negotiated between individual payers and providers. This situation has resulted in an opaque system in which payers with market power force weaker payers to cover disproportionate shares of providers’ fixed costs—a phenomenon sometimes termed cost shifting—or providers simply succeed in charging higher prices when they can. In this article I propose that this price-discriminatory system be replaced over time by an all-payer system as a means to better control costs and ensure equitable payment."

In particular, Prof Reinhardt points to the successful example of Maryland, which has historically deviated from other states in the US and has had an all-payer model of health services pricing. Maryland’s rate-setting system is widely believed to be one of the most enduring and successful cost containment programs in the United States. In his excellent paper, Prof Reinhardt finds evidence of price differentiation efficiencies at many levels. Private insurers pay much more for all services than public insurers, who use their larger bargaining power to lower prices.



For the same service, the variations in service fee are large in case of hospitals as against other treatment centers. There is an obvious high premium extracted by certain hospitals. The variations in payments across hospitals for the same service can be substantial.





The effectiveness of India's health insurance market will depend on it being able to get both the health service purchase and pricing model right. It is fortunate that being a nascent health insurance market, governments are not constrained by any legacy models. Since governments will be able to provide adequate health insurance to only a small proportion of the population, it is important that private health insurers too are able to keep their costs low and sell policies at affordable prices. Public policy should play a catalytic role in facilitating this.

The purchase model is more complex and not easily amenable to policy fixes. However, governments should encourage private insurers to adopt a purchase model that bundles services and makes payment for treatment of the medical condition. It is possible for governments to get health service providers as far away from the fee-per-service model of charging insurers. While it may be easier for large specialty hospitals to accept this, this model may end up excluding smaller diagnostic centers and clinics. Encouragingly, India's nascent health insurance model is, for various reasons, moving more towards the bundled purchase model than the fee-per-service model.

In case of pricing though, there is a more direct role for governments in assisting insurers arrive at standardized prices for services in all hospitals within a particular area. The model of all-payer price fixing, as is done in many continental European countries, would reduce the administrative and other transaction costs, and help keep insurance premiums at affordable levels.

In some ways, there is a free lunch here. Governments, both state and center, have an increasing leverage over private health service providers due to various newly announced state and central health insurance schemes. This strength should be used to bargain out standardized rates for services by participating hospitals within a geographical area. The private insurers could differentiate by offering variants of the basic service with top up prices.

Unfortunately, failure in this front is already evident in public health insurance. As I have blogged earlier, one of the critical failings with the Aarogyasri program was its inefficient price-fixing model. Other state governments, eager to embrace the wild populism inherent in Aarogyasri, may end up making the same mistakes.

Update 1 (3/3/2012)

Two excellent posts by Uwe Reinhardt on payment and pricing health insurance. The first dwells on the relative merits of the three purchasing models - fee for service, medical condition-based bundled payments, and capitation fee model. The second examines the three price determination models between the insurers and the insured and insurers and health care providers (doctors, clinics, hospitals etc) - free market negotiations, price-setting in quasi-markets (all payer system where the associations of health insurers within a region would negotiate with corresponding associations of hospitals, doctors etc uniform fee schedules that then would apply to all payers and providers in that region), and administrative price fixing by the government.

See also this paper by Prof Reinhardt on pricing in US hospital services.

The simplification of public debates

At the outset, let me clarify that this post is not a defence of any government. Nor is it an attempt to blame anybody. It is only a reflection of the environment in which public debates are taking place in modern societies.

Why is the government unable to lower inflation? Why is the government failing to provide employment to the massive numbers of people joining the workforce? Why is the government raising the prices of petrol and cooking gas periodically? Why is the government unwilling to tackle corruption? Why are governments failing to provide good quality utility services? Why are governments increasing the utility tariffs?

These are the dominant themes in our public debates today. The agenda of the debate is framed in a manner that puts governments at the center of the issue. The audience, mostly passive recipients, have come to believe that governments are either "failing", "unable", or "unwilling" to resolve these important and universal issues. Even when there is a rare attempt to search for the causes, it ends up in a circular manner reverting back to the government.

This framing of the agenda and questions suits all sides to the debate. The villain of the piece, government, is easily identifiable. This narrative fits nicely into the widely accepted stereotype of governments being the source of all evils. In this simplified world-view, citizens find easily identifiable villains. Most often, these debates end up as opportunities for collective middle-class catharsis. It is perfect staple for tweets and Facebook comments. They also make for good media events - soundbites, short op-ed columns, blog posts and half-hour television debates involving 4-6 people. The opposition and intelligentsia love it. The former's job is after all to oppose the government, while the later are known to just criticize, without offering solutions.

Ironically, governments too may not be unhappy. It helps them to avoid confronting the difficult issues that need to be addressed to meaningfully settle the issue being debated. In fact, it makes governments try out populist band-aid solutions which merely kick the can down the road. In many respects, we have a classic collective action problem.

The fundamental issues are complex, not amenable to quick-fixes, requires hard-thinking, and painstaking and long-drawn out action on multiple fronts. It involves all stakeholders facing up to bitter truths that unsettles and often discards the settled conventional wisdom. Most importantly, it requires communicating to all of us certain fundamental realities and the need to accommodate our opinions and ideologies based on them.

These issues are important for developing economy democracies like India, which are in the middle of far-reaching social and cultural transformations. These countries have a strong and deeply entrenched legacy of dominant government role in all walks of life. All the surviving generations are used to relying on governments to resolve all their problems. Accordingly, the dominant discourse invokes the language of regulations, enforcement, punishments, subsidies, and so on.

When governments are making pretences of controlling inflation by coming down on hoarders, or helping farmers by raising the minimum support price, or protecting consumers by keeping tariffs and oil prices unchanged, or controlling corruption by sending the corrupt to jail, it is this discourse that is being played out. This discourse has limited space to explain the complex dynamics of modern markets and the limitations of governments.

The theatrics associated with these debates means that we lose the opportunity for informed debates about critical issues of concern to all of us. In all these cases, since the government is the perceived villain, we stop or refrain from examining these issues in greater detail in search of "real" answers. Take the case of the debate surrounding inflation. What are its causes? What can be done to mitigate, in the short-term, and resolve, in the medium and long term, the causes of inflation? What should be the responsibility of governments, academicians, media, citizens and the society in this endeavour?

Or take the case of corruption. What are the major sources of corruption? What are the different categories of corruption and what are its dynamics? How can we systemically prevent rent-seeking for each category of corruption? What should be the role of different stakeholders in collectively addressing this problem?

This is not to be fatalistic - the resolution of all these problems require collective effort, and since such efforts are difficult to mobilize, we are left with no choice! But a more nuanced perspective of these issues and their challenges helps all participants in the debate to atleast appreciate the complex nature of the problem. I am sure all of us realize that we stand a better chance of success with addressing a complex issue when we have a well rounded understanding of the forces contributing to the problem.

If we are able to elevate public debates to this level, all of us will quickly realize that controlling inflation, job creation, keeping tariffs and user charges constant, and so on are issues that are increasingly beyond the competence of mere governments. They require long-term structural changes and societal adjustments, where all of us have an important role to play, either directly or by co-operating with and assisting in the process. The governments have to take the lead (sadly, even this is missing!).

However, as mentioned at the beginning, none of this is to underplay or overlook the central role of governments. They can, and should, play an important role (though their degree of control varies from situation to situation), in both mitigating the adverse consequences of these problems and putting in place the mechanisms to enable their effective resolution. Addressing market failures are the basic responsibility of governments. Public debates and policy making will be much the richer for this realization.

Power sector reforms - farm power and tariff revision

The Business Standard reports that the Union Power Ministry have advised State Governments to transfer the massive losses, estimated at Rs 1.06 lakh Cr at end of 2009-10, off the balance sheets of state distribution utilities. It has also advised that states take action to ensure no further cash losses.



If the bailouts or restructurings happen, it will be the second time in almost a decade that state distribution utilities have received such help. At the turn of the century, as part of the first flush of reforms in electricity sector across the country, many state electricity boards were bailed with a Rs 41,400 Cr package. State governments assumed the debts and issued long-term bonds.

Like with the earlier bailout, the present need for bailout appears to have been triggered by similar reasons - the near inevitability of widespread defaults to central generating utilities by state and private sector distribution utilities. This is a clear sign that very little appears to have changed with the sector except in processes and formalities.

In fact, for all the structural reforms that have been enacted in the sector over the past decade, central and state governments have refrained from addressing the twin-elephants in the room - limiting free power for agriculture and regular increases in power tariffs. Unbundling, private sector participation in generation, liberalization of regulatory restrictions in transmission and distribution, and operational improvements like loss reduction, can only get you to the starting line.

Any earnest and meaningful effort to reform the sector has to place farm sector reforms and periodic tariff revision at its center. There is nothing secret nor mysterious about this. Any trading enterprise can survive only if its cost of purchase and service delivery matches its price of delivery. In simple terms, the power procurement cost plus the transmission and distribution cost have to match the aggregate tariffs.

In fact, its importance for the long term health of the sector itself cannot be over-emphasized. The problems faced by privatized distribution utilities in Delhi, who too have massive pending dues with generators, is a reflection of the magnitude of the problems. If the present trends are allowed to continue, it will adversely affect the prospects of private sector generation too. Unlike state generation utilities, private generators will not be able to manage their operations without regular payments on their power sales.

In many respects, the current sorry state of affairs is a serious indictment of the state and central power sector regulators. It is also a classic case of how easily important reforms can be subverted and given lip-service in implementation. It also drives attention to the important issue of tariff revision and the need for public conditioning to accept such revisions.

1. The Electricity Act 2003 and the various state regulatory acts clearly mandates that utilities should not bear state subsidies and state governments should transfer upfront (and not reimburse) the subsidy amounts to utilities for all subsidies being implemented by them. The regulators are supposed to safeguard the interests of the regulated utilities through the annual tariff revision filings. They are mandated to fix tariffs in a manner that reflects utilities' cost of power procurement, a reasonable level of operational efficiency improvements (read loss reduction), and required capital and operational expenditures.

But regulators across states have made a mockery of this, accommodating the interests of their paymasters, the state governments, at the expense of the utilities they were statutorily mandated to protect. Tariff filings in most states have been reduced to a charade, an academic exercise, and most often unprofessional at that, that has no relevance to realities in the field. Regulators, barring a few occasions, have failed to exercise their due powers and force states to bite the bullet on tariff and farm power related issues.

2. The policies of state governments since the reforms were initiated is a classic example of how easy it is to subvert well-intentioned and critical reforms. States have not raised tariffs on domestic consumers for many years now. Assuming inflation and the general increase in cost of procurement, the real subsidy has increased massively. Free power to farmers has remained a holy cow. Even the issue of mere metering of agriculture services raises unbelievable amount of passions.

Even with the latest crisis facing utilities, and despite being fiscally constrained, state governments are unlikely to take any meaningful steps to address this issue on a sustainable basis. It will require commitment at the highest levels to stand even a reasonable chance with pushing through such reforms.

3. Despite nearly two decades of liberalization, the one area where public debate, both in the political realm and in popular media, has remained entrapped in the mindset of the bygone era is that relating to cost-recovery and tariff revision. We cannot shy away for too long from the inevitable fact that consumers have to pay the full cost of any service consumed by them.

Public and political opinion needs to be conditioned into accepting the reality that there are no free lunches. Apparent free lunches are unsustainable and cause serious indigestion down the line. Reforms are not just cheap talk. For any meaningful reforms in sectors like utility and municipal services, important structural reforms have to complement with cost-recovery in service delivery. In simple terms, the culture of free or subsidized delivery has to end. At best, cost-recovery can be ensured in the aggregate through some form of cross-subsidization.

There can be a silver-lining to the crisis. If utilities are to be bailed out, it is a great opportunity for all stakeholders - regulators, state and central governments - come together and agree on some minimum steps with reforming farm power and tariff revision. This blog has always talked about scalable and practical steps in public policy reforms. However, the time may have come to stretch the definition of practicability given the serious magnitude of crisis facing power sector in India. I can think of three such minimal set of steps

1. All agriculture services should be metered. Leave alone bringing in efficiency and accountability in farm power consumption, this is an absolute essential requirement for many upstream reforms. For example, current estimates of distribution losses are badly flawed in the absence of any reliable estimate of agriculture consumption. It is common practice for utilities and regulators to use this as a sinkhole to doctor various operational efficiency and tariff figures that suit their respective agendas.

2. There is scope of considerable reforms with the terms of free farm power supply. To start with, free power supply should be restricted to only certain types of farmers, with the restriction being confined to easily enforceable or detectable parameters or proxy parameters. As I have blogged earlier, governments should move over to a system of fixed monthly units for agriculture consumption, to be reimbursed into the farmers accounts when they pay their monthly farm and domestic supply bills. Its benefits are manifold and the availability of Aadhaar, atleast in certain areas, makes the logistics simpler.

3. Periodic tariff revision, for all categories of consumers, must be made mandatory. In fact, even a simple, rule of thumb increase based on inflation or some other fixed parameter, will be one of the biggest boost for the sector. Just as was done to encourage unbundling of state utilities in the first generation of reforms, state governments should be directed to enter into MoUs or agreements with their utilities or mandate rules that define the terms for periodic tariff revisions. A mandatory and automatic requirement to periodically revise tariffs, agreed between all states and the centre can overcome, atleast partially, the political and collective action problems that accompany such hard reforms.

Cost effectiveness and public service delivery

Any true test of a public policy intervention should involve not only an assessment of its defined program outcomes but also its cost-effectiveness in achieving those outcomes. In other words, assuming a set of desired outcomes, which policy approach generates the greatest bang for the buck?

I am inclined to accept the argument that in any real world development intervention, defining the outcomes is essentially a political decision, and therefore the preserve of the respective Department Ministers or the Cabinet. In contrast, structuring the policy design and implementation strategy for a chosen intervention is a bureaucratic/administrative and technical decision, the domain of officials and experts. It is their responsibility to help make an informed choice from among competing policy design alternatives. However, most often, in the real world of policy design and implementation, optimal policy design and cost-effectiveness takes the backseat.

Consider this example. The government of Populismland decides to provide free tertiary medical care and free secondary and higher education, including in private hospitals and colleges, for all those living below the official state poverty line, the BPL. The political objective is laudable. I have already written about the increasing importance of interventionist public policy in education and health care to address glaring market failures.

After the normal inter-departmental consultations, the bureaucrats of Health and Education Departments of Populismland draft their respective implementation strategies. The Health Department proposes the establishment of a government-run Trust to manage the tertiary healthcare program. In order to squeeze out the last ounce of populism, the program provides the ultimate choice to patients to take treatment in any hospital, public and private.

The Education Department too follows a similar script. To ensure that every student belonging to a BPL family gets all types of education for free, in private or government colleges, it formulates a policy that reimburses the full fees to all these students. Colleges fix fees, students apply and get admission, scholarships are sanctioned and disbursed. Simple!

In simple terms, in both cases, all the students belonging to the official BPL category, are offered the unparalleled choice of treatment and education in the best possible hospitals and colleges respectively. As indicated earlier, in both cases, the bureaucrats of Populismland have responded to the dictates of their political masters by tailoring simple but extremely expensive and unsustainable policy designs. How could the bureaucrats of Populismland have done better?

In simple quantitative terms, assuming the objectives, the single most important parameter is the expenditure per person per year for health care and education respectively. In commercial health care and education markets, this is determined by the insurance premium and the interest rate on education loans respectively. Optimal public policy design mandates that it be structured in a manner such that it is atleast as cost-effective as either of these.

Now, in most cases, and certainly with health and education, this would require drawing on professional expertise. The rote and unprofessional manner of policy formulation, commonplace with bureaucratic public policy designs, cannot achieve the objective of cost-effectiveness. So how can the bureaucrats of Populismland address the challenge of cost-effectiveness with its pre-defined healthcare and education interventions.

For a start, in both cases, there should be serious debate about what constitutes eligibility. In some respects, this is the most important determinant of total cost of such programs. In health care, the challenge lies in designing the cheapest and least distortionary insurance scheme. I have blogged earlier here and here about the principles that should underpin such schemes.

In education, the issues are more complex. The challenge would be to provide affordable and good quality college education, in both private or public institutions, at the lowest cost, without creating systemic distortions. A robust mechanism for scholarship sanction and rigorous monitoring its utilization should be established. Incentives that relate sanctions and disbursal to the performance of both students and colleges are an essential requirement. Critical to keeping costs down is a rigorous process of fixing the fee amounts for various college degrees to be reimbursed for those covered under the scheme.

Alternatively, is it possible for public policy to catalyze a carefully regulated but efficient market in education scholarships. Enabling policy framework can be established to encourage banks and other financial institutions to offer student loans. Subsidies, both on interest and principal, of varying amounts, can be offered to students depending on their family incomes. The institutions eligible to be part of any government subsidized loans should be rigorously screened. The exact design of each student loan, and the extent of government support can vary depending on the type of courses.

For example, those studying in professional colleges, and getting placed should take over atleast some portion of their loan. Similarly, those performing poorly in certain school courses should be permitted to avail scholarships only for certain categories of subsequent courses.

In conclusion, any policy which simply doles out assistance, either directly or indirectly, without aligning incentives and preventing systemic incentive distortions, is a recipe for disaster. More importantly, it is a clear case of abdication of their responsibilities by administrators.